The Max Pain theory predicts a stock will close at the strike that destroys the most value from option buyers. Because of this, Apple (AAPL) usually trades between certain prices and is being artificially held down and at rare times, held up. In essence, the options market is holding AAPL captive; the common stock is now a derivative of the options. The advent of weekly options has exacerbated this problem and, for the most part, has AAPL in lock down mode.
Fact Based Data
The Option Writers Playground
The following image (1.1) is a rough spreadsheet showing AAPL options since it began trading weekly. The green cells show when AAPL closed between the highest open interest (OI) of puts and calls. The red cells show when AAPL closed outside of this range. The yellow shows the stock closing within $1.00 and the orange denotes news or events that caused excessive volume or volatility.
click to enlarge (or view here)
Game Over, Please Insert More Tokens
Image 1.1 shows 48 weeks of samples; only 8 times did AAPL close outside the highest OI range. This gives the traders who wrote options at the highest OI strikes an 83% probability trade if you discount news or events that caused excessive volatility. You may look at this data and not see it of much use, for example on December 17th, 2010 a $50 spread was recorded between puts and calls. It must be noted this data is using the absolute highest OI as if a computer model was reading it, some of those larger spreads, if interpreted by an experienced eye, can see would have been much closer. In this December 17th example, the $310 put was your tradable floor as the OI was just shy of the $280 strike.
The image below (1.2) represents the same exact data from image 1.1 but with a 1 strike margin for error (1 additional out-of-the-money strike). What you can see is the probability is greatly improved to 98% (discounting events).
Click to enlarge (or view here)
What Does the Data Look Like?
The image (2.1) below shows what Wednesday May 25th AAPL Weekly OI looked like in chart form. The high of the day was $338.56.
The following image (2.2) is the Friday, May 27th AAPL Weekly OI chart. The closing price for AAPL was $337.41.
Opinion Based Analysis
How Is The Game Played?
AAPL is under the arm of option writers and for the most part commercial money writes options. They will dictate AAPL's direction and close it where they have to pay out the least amount of insurance (above the highest OI puts and below the highest OI calls). There is not a room full of traders doing this, it is a group of traders around the world that all have the same bet or collective interest and will control the price of AAPL that suits them best.
I look to the highest OI for insight as this is the point which has the most strength to control AAPL. In other words, the highest OI strikes have the most collective buying or selling power. When you try to pick an exact max pain point, e.g, $335.00, well who has the bigger bank account? The person who wrote the $335 calls or the $335 puts? So I don't try to fine tune it but sell the outside ranges. Call it manipulation, call it perfectly normal delta/gamma hedging, just don't say options are not controlling AAPL.
It is paramount to know when an event of any kind occurs or is near, volume/momentum − like any frenzy − takes over and it is not possible to predict the outcome or jockey the stock to an exact max pain point. I discount events.
Let’s take a look at image 2.1. Notice how the high OI was relatively even between puts and calls, on this day AAPL had a high of $338.56. With AAPL trading so close to $340 it allowed a heavy amount of $340 calls to be opened. Fast forward to Friday of that week and image 2.2. Does anyone have any doubt why AAPL came back down from the $340 area now? Oh, maybe because the $340 OI just became the Great Wall of China. Option writers do not benefit with AAPL above $340 and it is in their best interest for the stock to go away from the highest OI strike. Remember this OI is from the day before, this is why we do not use an exact max pain number, as we never truly know Friday’s OI as many contracts are closed up and this again shifts the strikes or exact pain.
Referring to image 1.1, notice the big run AAPL had in September, which resulted in multiple red cells. This happens when a stock finally breaks free from the grip of the options market; a catalyst usually does this. Once that happens it will typically keep breaking through until momentum stops and the options market can take control again.
Future analysis can look into a more fine tuned way to trade this data. Topics should include how the highest OI will fluctuate a strike or 2, what to do about this and how to be agile by rolling your positions up or down. We also need to be made aware if total put or call OI becomes very skewed, we will need to only play one side, as a visual aid see image 3.1 below. This is based on the observation AAPL moves away from high OI.
Weeks Of Foresight, 20/20 Vision Ensues
In my study I have found you can only look one month into the future with accuracy. This theory has no desire to guess where AAPL will be. Knowing where it won't be gives us much higher probability. As a trader this is what we are looking for. We want to mimic insurance or casino models and piggy back these funds. This study concludes that options should be sold rather than bought and leaves you with this: If you can’t beat ‘em, join ‘em.
Disclosure: I am long AAPL.
Additional disclosure: Short Put Spread, Short Covered Calls.